Aggregate Expenditure Components

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Aggregate Expenditure Components

• Chapter 9

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Individual Consumption and Savings

• All disposable income is either consumed or
  saved.
• For the individual, what happens to savings as
  income increases.
• This theoretical result is backed up by evidence
  from real micro data.

Consumption/Savings
Consumption Savings
Consumption
Savings
o
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Real Disposable Income
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Exhibit 1 Disposable Income, Consumption, and
Saving

• As our economy has grown, the relationship
  between disposable income and consumption has
  been relatively constant and stable over time
• Saving is the difference between disposable
  income and consumption.
• Savings have grown somewhat, butit hasnt kept
  pace with the economic growth.

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Exhibit 2 U.S. Consumption Depends on
Disposable Income
Consumption has grown along with disposable
income.
What is the value of savings for 1985?
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The Aggregate Consumption Function

• The relationship between consumption and income,
  other things constant
• Consumption is the dependent variable
• Disposable income is the independent variable.
• No income means no consumption
• Because consumption depends on income, it is a
  function of income

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Exhibit 3 The Consumption Function

• In this graph, both disposable income and
  consumption are measured in real terms, or in
  inflation-adjusted dollars
• Consumption increases with disposable income,
  assuming other determinants of consumption remain
  constant
• Notice the angle of the line remains less than 45
  degrees.

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Exhibit 4a Marginal Propensity to Consume

• Slope of the consumption function equals the
  marginal propensity to consume
• In this case, the change in consumption is 0.4
  trillion and the change in income is 0.5
  trillion the marginal propensity to consume
  0.4 / 0.5 or 4/5
• If the angle were 45 deg, what would the MPC have
  to be???

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Exhibit 4b Marginal Propensity to Save

• Income that is not spent is saved
• Here, saving increases by 0.1 trillion as a
  result of a 0.5 trillion increase in income
• The marginal propensity to save, MPS, equals 0.1
  / 0.5, or 1/5
• Generally, MPC MPS 1

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Why is it important to know the MPC and/or the
MPS?

• It allows us to calculate the effect of changes
  in disposable income, holding other non-income
  determinants constant.
• What changes DI (wages, taxes, transfer payments)
• It also allows us to estimate the effects of
  shocks or changes to the economy. (examples)
• Increases in oil prices
• Rising medical prices
• General inflation
• Allows us to estimate the effect of tax cuts, or
  rebate checks (fiscal policy)

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Non-income Determinants of Cons.

• What are these factors that could cause the
  entire consumption function to shift?
• Net wealth
• Price level
• Interest rate
• Expectations

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Net Wealth

• Net wealth is the value of all assets that
  households own minus any liabilities, or debts
  owed
• A decrease in net wealth would make consumers
  less inclined to spend, more inclined to save
• Increase in net wealth increases consumption

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Net Wealth

• What are things that could change your net
  wealth?
• Housing price appreciation
• Stock appreciation
• Inheritance
• What are (or have been) their effects on
  consumption?

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Exhibit 5 Shifts in the Consumption Function

• Increase in net wealth shifts consumption
  function from C to C''
• Decrease in net wealth shifts it from C to C'

C
Real Consumption
0
Real disposable income
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Shifts and Movements Along

• Difference between a movement along the
  consumption function and a shift of the
  consumption function
• Movement along the consumption function results
  from a change in disposable income (from tax
  changes, transfer payment changes, or wages).
• Shift of the consumption function results from a
  change in one of the non-income determinants of
  consumption

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Price Level

• When price level changes, real value of
  dollar-denominated financial assets (bank
  accounts, cash) also changes
• Increase in the price level reduces the
  purchasing power of wealth held in fixed dollar
  assets households consume less and save more
• Decreases in the price level increase the
  purchasing power of wealth held in fixed assets
  households consume more and save less

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Price Level

• We can think of several examples of price changes
  that might reduce real disposable income and,
  thus consumption.
• Fuel prices
• Housing prices (rent)
• Tuition, Activities, Athletic Fees!!!
• What are the effects on younow think of it
  applied to the entire economy???

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Interest Rate

• Interest
• The reward savers earn for deferring consumption
• The cost paid by borrowers for current spending
  power
• The higher the interest rate, the less is spent
  on items purchased on credit (households save
  more and borrow less) and the consumption
  function shifts downwardCredit has become more
  expensive.
• Conversely, a lower interest rate shifts the
  consumption function upward

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Expectations

• Changing expectations about price levels,
  interest rates, job security and other such
  factors influence consumer behavior
• If expectations become more pessimistic, then
  consumption function shifts downward
• If expectations become more optimistic, then
  consumption function shifts upward

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Expectations

• What is happening to the average age of the US
  population???
• What effect might this have on the price of
  medical services?
• What are your expectations of future fuel prices?
• What are your expectations of future housing
  prices?
• What are your expectations for your wages?

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Investment

• Investment consists of spending on
• New factories and new equipment
• New housing
• Net change in inventories
• NOTE INVESTMENT IS NOT THE PURCHASE OF STOCK IN
  A COMPANY OR BONDS. THIS IS A FINANCIAL ASSET
  AND DOES NOT ADD TO THE PRODUCTIVE CAPACITY.
• Firms invest in capital goods now in the
  expectation of a future return or profits
• Since return is in the future, investors must
  estimate how much a particular investment will
  yield in all years of its productive life

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Demand for Investment

• Firms buy new capital goods only if they expect
  this investment to yield a greater return than
  other possible uses of their funds
• The expected rate of return equals the annual
  dollar earnings expected from the investment
  divided by the purchase price
• Market interest rate is the opportunity cost of
  investing in capital

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Exhibit 6 Rate of Return on Golf Carts and the
Opportunity Cost of Funds
Golf carts cost 2k, and rental income decreases
for each added cart.
400/2000
300/2000
200/2000
100/2000
Will not be rented
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Exhibit 6 Rate of Return on Golf Carts and the
Opportunity Cost of Funds
Any investment that returns less than the market
rate of interest is not going to be made.
Rather, the investor will place the cash into an
interest bearing account (the next best
alternativeor, in this casethe best alternative
when the return from investment drop to or below
8)
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Exhibit 7 Investment Demand Curve for the Economy

• Shows the inverse relationship between the
  quantity of investment demanded and the market
  interest rate, other things constant.
• Sums the investment demanded by each firm at each
  interest rate.
• At lower interest rates, more investment projects
  become profitable for individual firms, so total
  investment in the economy increases.
• Lower interest also means lower opportunity
  costs!!!

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Planned Investment and Income

• Investment depends more on interest rates and on
  business expectations than on the prevailing
  level of income
• Thus, the investment decision is said to be
  forward looking, based more on expected profit
  than on current levels of income and output

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Investment Function

• The investment function isolates the relationship
  between the level of income in the economy and
  planned investment the amount firms would like
  to invest, other things constant
• Two determinants of investment assumed to be
  constant are
• The market interest rate
• Business expectations

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Market Interest Rate, Business Expectations

• A decline in the rate of interest, other things
  remaining constant, will reduce the cost of
  borrowing and increase planned investment
  investment function shifts upward
• Conversely, when the interest rate increases, the
  planned investment function shifts downward
• If expectations of profits are high, businesses
  invest
• If expectations of profits are low, investment
  falls

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Business Expectations

• Factors that could affect business expectations
  and investment include
• Wars
• Technological change
• Changes in the tax structure
• Other destabilizing events that make long-term
  planning more uncertain

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Exhibit 8 Planned Investment Function
The horizontal investment functions imply that
planned investment does not vary with real
disposable income, it is autonomous

Real planned investment (trillions of dollars)

1.0
I
0 2.0 4.0 6.0 8.0 10.0
12.0 14.0
Real disposable income
(trillions of dollars)
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Exhibit 9 Annual Percentage Change in U.S. Real
GDP, Consumption, Investment
Investment is Volatile!!!
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Government Purchase Function

• Government purchase function relates government
  purchases to the level of income in the economy,
  other things constant
• Decisions about government purchases do not
  depend directly on the level of income in the
  economy
• We assume for now that G is autonomous

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Transfer Payments

• Transfer payments are another government outlay
• Outright gifts from governments to households and
  are thus not considered part of aggregate
  expenditure
• Social Security
• Welfare benefits and Unemployment benefits
• Make up about a third of government outlays
• Transfer payments vary inversely with income as
  income increases, transfer payments decline

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Net Taxes

• Governments impose taxes to fund expenditures
• Net taxes equal taxes minus transfers and are
  independent of income
• Taxes tend to increase with income while
  transfers decrease with incomei.e., they offset
• Net taxes affect aggregate spending indirectly by
  changing disposable income, in turn changing
  consumption
• Again, for now we assume that Net Taxes are not
  related to income (Autonomous).

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Net Exports and Income

• How do imports and exports relate to the level of
  income in the economy?
• When incomes rise, Americans spend more on
  everything including imports and when incomes
  decline, Americans spend less on imports
• The exports purchased by the rest of the world
  depends on the income of foreigners, not on the
  U.S. level of income

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Net Export Function

• Shows the relationship between net exports and
  the level of income in the economy, other things
  constant
• Exports are relatively insensitive to level of
  U.S. income, but imports tend to increase with
  income
• Net exports (exports minus imports) tend to
  decline as U.S. income increases
• For simplicity, assume for now that net exports
  are autonomous and independent of the level of
  income

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Nonincome Determinants of Net Exports

• Factors assumed constant along the net export
  function include
• The U.S. price level
• Price levels in other countries
• Interest rates here and abroad
• Foreign income levels
• Exchange rates between the dollar and foreign
  currencies

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Exchange rates between the dollar and foreign
currencies

• Exports
• If the value of the dollar rises relative to
  other currencies, this makes US exports more
  expensive on the world market
• If the value of the dollar falls relative to
  other currencies, this makes US exports less
  expensive on the world market

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Exchange rates between the dollar and foreign
currencies

• Imports
• If the value of the dollar rises relative to
  other currencies, this makes imports less
  expensive in the US.
• If the value of the dollar falls relative to
  other currencies, this makes imports more
  expensive in the US.

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Exhibit 10 Net Export Function
Increasing X, decreasing M or both
decreasing X, increasing M or both
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Exhibit 11 U.S. Spending Components as
Percentages of GDP Since 1959